6 Structured Products

Question 1

What is the Put-Call Parity Equation

Answer 1

Stock (Asset) + Put = Bond + Call

Question 2

Collar =

Answer 2

Buy Put, Sell Call

Question 3

The value of a levered firm’s risky debt is equivalent to owning a RISKLESS BOND and SELLING a PUT OPTION on the firm’s assets. At maturity, this may be expressed as:

Answer 3

K - max(K - V(T), 0)

Question 4

The equity value of a levered firm is equivalent to a LONG CALL on FIRM’S ASSETS. The value of a call on the firm’s assets is the greater of zero and the difference between the value of the firm’s assets (V) and the face value of debt. At the debt’s maturity date, this may be expressed as:

Answer 4

max(V(T) - K, 0)

Question 5

option positions corresponds to the mezzanine tranche of a collateralized debt obligation?

Answer 5

1. Mezzanine tranche is similar to Collar (i.e., long asset + short call + long put with lower strike)
2. Bull call spread (i.e., long call with lower strike + short call with higher strike)
3. Bull put spread (i.e., long put with lower strike + short put with higher strike)

Question 6

In Merton’s structural approach to pricing credit risk, the value of a firm’s equity and risky debt may be viewed in terms of which of the following options?

Answer 6

In Merton’s structural model, the firm’s equity value is viewed as a long call on the firm’s assets and the firm’s risky debt value is viewed as the value of a riskless bond and the payoff from a short put option on the firm’s assets.

Question 7

CMO repayment sequence

Answer 7

Pays interest for all, then principal

Question 8

How to calculate CDO payout

Answer 8

• Senior tranches are paid first
• If yields go down, see if it impacts the senior tranches. It may only impact equity.
• Senior tranches paid in full whenever possible.

Question 9

Bondholders hold
- ____ Vega exposure
- ____ put option position

Answer 9

short

Question 10

Debt of levered firm =

Answer 10

Riskless bond - Put

or Put = Riskless bond - put

Question 11

MERTON’s CALL option view of capital structure:

1. Equity of levered firm =
2. Firm’s debt =

Answer 11

1. Equity of levered firm = Long call option on firm’s assets
2. Firm’s debt = Long assets + short call on assets (covered call)

Question 12

MERTON’s PUT option view of capital structure:

1. Debt of levered firm =

Answer 12

1. Debt of levered firm = Riskless bond - Put on assets

Put option represents market price for bearing firm’s credit risk
Put option represents equity owner’s ability to put firm’s assets to debt holders by declaring bankruptcy
If firm performs poorly, debt holders suffer losses since they must pay stockholders a strike = value of the diskless bond

Question 13

Value of levered firm:

Answer 13

Asset = Equity + Debt
Asset = Bond + Call - Put

Question 14

Detachment point in CDO

Answer 14

highest percentage loss in the collateral pool that completely wipe out the tranche

Question 15

Main difference between a total return swap and a credit default swap

Answer 15

The main difference between a total return swap and a credit default swap (CDS) is how payments are made.
- With a total return swap, payments reflect changes in the market value of the underlying credit-risky asset.
- With a CDS, the payment is made only if a predetermined credit event happens.

Question 16

Describe the cash flows for the credit protection seller of a total return swap

Answer 16

Receive: total return on risky asset
Pay: fixed, periodic payment

Question 17

Sumen, Inc.’s one-year zero-coupon bond yields 6.8% per year. It is estimated that the bond’s recovery rate is 92% and its credit spread is 2.3%. Which of the following comes closest to the exact and approximate risk-neutral probability of default, respectively, attained using the reduced-form model?

Answer 17

REDUCED: S / (1-RR) = 0.023 / (1-0.92) = 0.2875

EXACT: Reduced / notional = 0.2875 / 1.068 = 0.2692

Question 18

Which exposures do these CDS indices offer you exposure to:
1. CDX
2. iTraxx

Answer 18

CDX provides exposure to investment-grade companies in North America and emerging markets.

iTraxx provides exposure to companies in Europe, Asia, and Australia.

Question 19

Qualifying Affliate Guarantee refers to

Answer 19

An obligation of a subsidiary of a CDS’s referenced entity, if the subsidiary is at least 50% owned by the referenced entity, that may be delivered by the credit protection BUYER to the credit protection SELLER in a CDS.

Question 20

An investor sells 5-year protection using a credit default swap. A tightening in the default swap premium of the reference entity would result in

Answer 20

• Positive MTM
• Gain to Protection seller

Question 21

Difference in cash flows between the following:
1. CDS
2. CLN
3. TRS
4. Credit Option

Answer 21

CDS: series of payments from buyer to seller
CLN/TRS: not a single payout
Credit Option: Single

Question 22

The WARF measures the average credit rating of the CDO collateral or tranches?

Answer 22

Collateral

Question 23

CDOs on demand

Answer 23

Single-tranche CDOs provide more customization of CDO terms for their investors compared to other types of CDOs. Therefore, they are often referred to as “CDOs on demand” or “bespoke CDOs.”

Question 24

Calculating overcollateralisation

Answer 24

Total Assets / Senior Tranche

Question 25

A four-year zero-coupon cash-and-call position with an initial cost of $1,000 pays the greater of $1,000 and $1,000 compounded at 3.7% per year for four years. Which of the following best represents the value of the cash-and-call strategy’s call option?

Answer 25

cash-and-call strategy involves investing in a riskless asset (i.e., cash) or a portfolio of riskless assets and call options. This cash-and-call strategy provides $1,000 principal protection. The difference between the $1,000 principal and the current zero-coupon bond price is invested in call options.

Current zero-coupon bond price (i.e., PV of minimum $1,000 payout) = FV / (1+r)t = $1000 / (1+0.037)4 = $864.74

Of the $1,000 initial cost, $864.74 is invested in cash (i.e., the zero-coupon bond) and the rest (i.e., $1,000 – $864.74 = $135.26) is invested in a call option with a strike of $1,000.

Question 26

What does the SHAPE of the payoff diagram represent?

Answer 26

The payoff diagram shape indicates the RISK EXPOSURE of a product relative to an underlying asset. The shape of payoff diagrams can be analyzed by investors to ascertain the extent to which a product’s payoffs align with investors’ risk preferences or market view of the underlying asset’s return distribution.

The payoff diagram LEVEL indicates the return investors can expect to receive from a product and thus indicates whether the product is appropriately priced or not.

Question 27

PDE vs Building Block

Answer 27

PDE: Dynamic Hedging
BB: Static Hedging

Question 28

Which of the following strategies has the same payoff as a cash-and-call strategy?
1. Protective Put
2. Short Straddle
3. Covered Call
4. Long Put

Answer 28

1. Protective Put: long cash + long call

Question 29

What is the exchangeable certificate?

Answer 29

The exchangeable certificate is a capital protection structured product that, like a call option, offers downside protection and 100% participation in profits (i.e., the holder participates without limit in any gains that exceed the strike price). The upside participation takes effect after a specified increase in the value of the underlying asset.

Question 30

In a power reverse dual-currency note, an investor pays a fixed interest rate in one currency in exchange for a payment based on which of the following?

Answer 30

pays a FIXED interest rate in one currency in exchange for a payment based on a FIXED interest rate in another currency, which increases or decreases depending on CHANGES in FX

Question 31

Spread Option vs Option Spread

Answer 31

A SPREAD OPTION is an option whose payoff depends on the DIFFERENCES IN PRICE BETWEEN 2 UNDERLYING assets or indices. Therefore, a call option on the difference in prices of crude oil and heating oil is an example of a spread option.

OPTION SPREAD is bull spread or calendar spread